A car's residual value refers to its estimated dollar value at the end of a car lease or useful life. The actual residual value of a particular vehicle varies. Residual value is essentially an estimate of what that specific car's value will be in a set time, usually between two and five years. If you spend much time at a car dealership looking to lease a new or used car, you'll hear this term thrown around quite a bit.
Here's an explainer about residual value and why you should pay attention to it when considering a new car.
Why Residual Value is Important
Residual value is significant because it helps determine the monthly payment you'll make on a leased vehicle. Moreover, it helps calculate the amount you'll pay if you decide to buy out the car at the end of your lease term. And that's helpful when budgeting your car payment over any amount of time.
It is essential to know that residual value and resale value are not the same. Resale value can vary widely, and is based on the car's depreciation, any damage sustained over its lifetime, its mileage, and current market conditions, among other things. On the other hand, residual value is predetermined and based on a commonly used formula throughout the auto industry.
Who Determines a Car's Residual Value?
As of 2018, auto lending companies determine the residual value of a given car; the dealer does not determine this value.
The lending company calculates or obtains the residual value of a vehicle by:
- Consulting a leasing guide
- Calculating a percentage of the Manufacturer's Suggested Retail Price (MSRP)
Automotive Lease Guide (ALG) is the industry benchmark when it comes to a car's residual value. ALG publishes an annual Residual Percentage Guide for reference. Residual values in the Residual Percentage Guide are an authoritative prediction that most of the auto industry follows. ALG residual values are not etched in stone, and lenders take the liberty to establish unique residual values even for the exact vehicle in the same condition.
Similarly, calculating a percentage of MSRP leads to residual values that differ between lenders. For example, one lender calculates the residual value at 30% of MSRP. Another lender calculates the residual value at 40%. Both residual values may apply to the same vehicle at the end of a 36-month lease, and these values are not negotiable. That's why it's advisable to shop around for multiple lenders. It's possible to come across a range of residual values for any vehicle you're considering leasing.
How do You Determine a Car's Residual Value On Your Own
When determining the value of the car you want to sell or buy/lease, consult leased car guides like ALG, available via an annual subscription. In addition, there are free alternatives online, such as Kelley Blue Book. Some online tools give you a prediction of your car's residual value. In contrast, other tools allow you to input information and parameters beforehand to help them arrive at an educated guess about your car's potential residual worth. Essentially, these tools calculate your car's residual value based on your input and established parameters/refinements.
Online person-to-person car sales websites are another idea. These websites often offer some tool that calculates residual car values, trade-in value, or trade-in range so that you can post your for-sale vehicle at the most competitive price. On the surface, residual value and trade-in-value seem different. However, trade-in value only estimates what a used car might fetch at auction, one of the metrics used to determine residual value.
How Does ALG Establish Baseline Industry Standards?
ALG tracks how vehicles depreciate over time. Based on extensive experience with vehicle depreciation, ALG produces residual value forecasts. The residual value, or expected wholesale value, is the price that your used car might fetch at auction. This forecast calculation includes the price history of similar vehicles sold at auction after the end of the lease term and is a good option for helping to determine the value of an asset.
The lender — bank, credit union, or automaker's finance unit — uses the ALG residual value forecasts, its own set of past models, and predictions to establish a unique residual value for a given car. This residual value calculation (which includes depreciation), along with the assessed interest rate and tax, impacts the amount of your car's monthly lease payments. As a result, the lease offer from the lender is the one that it thinks is the most competitive, profitable, and compatible with the lender's most comfortable level of risk based on the residual value of the vehicle.
Some manufacturers subsidize leases. The contracts for these leases often quote slightly higher residual car values than those from ALG. These higher values let manufacturers offer lower monthly payments and smaller down payment options on leased vehicles, which some consumers may find more feasible.
What is Residual Value in Relation to MSRP?
MSRP only applies to new, unused cars. When you buy a vehicle or sign a lease agreement and drive it out of the lot, its value diminishes. That's why residual value represents a percentage of MSRP. MSRP is a manufacturer's calculation of retail pricing; the price is suggested. It doesn't reflect what a car sells for or even what it costs.
Manufacturers use a variety of formulas and methods to determine MSRP. The basic formula is: Cost of product + markup = MSRP.
After you drive a new car off the lot, the value continues to depreciate the more you use it. The most significant portion of your monthly lease payment covers the cost of depreciation. So does it follow that a car with a high MSRP automatically has a higher value depreciation? Not necessarily so.
More Affordable Luxury Cars?
Sometimes it makes more sense to look for lease deals on and lease a luxury vehicle that happens to have a higher MSRP. A well-made luxury vehicle depreciates less during the lease period, meaning your monthly lease payment may end up being lower than a monthly lease payment for a cheaper car whose value rapidly depreciates over time. Since the luxury car depreciates slower than the economy car, it retains more resale value/market value than other leased vehicle types. In this instance, the residual value of the vehicle is greater.
Valued Within the Industry
High residual value is so prized that the industry grants annual awards to manufacturers whose vehicles depreciate the least over a three- to five-year period. In addition, pay attention to manufacturers awarded "Highest Resale" or "Highest Residual Value" awards from independent third-party outlets. It's a crucial indicator of which brands and models hold their value the most because of higher residual value overall.
Knowing What Your Vehicle is Worth
Knowing residual car values helps you make more sound decisions about what's worth leasing before entering into a lease contract or considering a lease buyout with your current leasing company. Whether your future car is luxury, sporty or economical, your car's ability to retain value automatically means lower monthly lease payments. It also means you derive greater actual, perceived, and overall value from your car for years and years to come. That way, you become a savvier lessee with a car that offers a future value and even an end value that you're comfortable with at the end of your lease.